Nowhere to run

As fears over the eurozone’s spreading debt contagion gathered at the end of May, China’s State Administration of Foreign Exchange (SAFE) found itself cast as the euro’s greatest champion.

"Europe has been and will continue to be one of the major markets for investing China’s exchange reserves," SAFE said in response to what it called a "groundless" report that it was reviewing its holdings of euro debt.

By denying that it was reconsidering its euro position, and expressing its long-term commitment to the currency, the agency hoped to restore confidence in the market, and to prevent further losses to China’s own euro holdings.

It worked, at least for a while. Global markets, which had been in a free-fall, stabilized. The day after SAFE’s announcement, major European indicators and the S&P 500 rose more than 3%, and the euro itself arrested its fall.

The effect was not to last. As troubles in the eurozone nations have continued to grow, pessimism about the euro has returned. Even after a brief rally in mid-June restored some strength to the euro, it remained down nearly 15% against the renminbi and US dollar since the beginning of the year.
Few options

For China, which is estimated to have euro holdings worth US$630 billion, the currency’s continued fall has been a matter of real concern. However, faced with few options for investing its foreign reserves – and with the world watching its moves closely – SAFE is unlikely to significantly alter its approach to euro debt.

"The issue for China right now is that if they don’t buy euros, what else can they buy?" said Jeffrey Yu, a currency strategist at UBS in London. "I think China is going to keep its current balance between dollars and euros, with the difference being they’re going to be more selective with what kinds of assets they buy."

The specific makeup of China’s US$2.4 trillion in foreign reserves is not disclosed. By most estimates, US dollar assets make up about two-thirds of total holdings, with the rest made up mostly of euros, and some yen and pounds sterling.

After the financial crisis hit the US dollar in 2008, Chinese officials were keen to criticize US currency policy. Zhou Xiaochuan, the central bank governor, even publicly mulled the end of the US dollar’s reign as a global reserve currency. In response, US officials including Secretary of State Hillary Clinton urged China to continue buying US Treasury bills, China’s preferred dollar-denominated asset.

In the end, it was mostly for show: The knowledge that dumping Treasury bills would hurt China at least as much as the US kept SAFE from following through on its threats. In fact, China remained the largest buyer of US Treasury securities throughout 2009, and even increased its purchasing from US$763.5 billion in April 2009 to US$939.9 billion in July. China bought US$900.2 billion of the securities in April this year.

The country’s public approach to the euro crisis has been comparatively friendly. In place of sell-off threats, China has taken pains to reaffirm its commitment to Europe, and European Central Bank officials have not had to resort to begging to ensure that Beijing continues to hold its euro assets.

Partly, this is a matter of China’s relatively smaller exposure to the euro. But Chris Leung, senior economist at DBS in Hong Kong, says the impact of politics shouldn’t be understated.

"Politically speaking, China’s relationship with the EU seems to be better than with the US … Germany in particular has very good business [relations] with China," he said.

China to the rescue

Going beyond SAFE’s words of support at the end of May, Beijing made headlines in mid-June with the announcement of a major investment in Greece, the fountainhead of the eurozone’s debt crisis. State-owned shipping firm China COSCO (601919.SH, 1919.HK) took control over the Greek port of Piraeus in exchange for investing US$700 million into upgrading the port’s facilities.

In the long term, this investment is an opportunity to strengthen China’s position as an exporter to Europe and North Africa. However, while discussions certainly pre-dated Greece’s financial woes, the timing of the announcement signaled that it was more than just a port deal: It showed that China is committed to ensuring the continued strength of the eurozone, and to supporting the euro as an alternative to the US dollar.

The lack of dollar alternatives may be China’s most pressing reason for backing the euro. For all the currency’s weakness, it has a major advantage – liquidity – over so-called "commodity" currencies like the Canadian and Australian dollars. The yen’s usefulness as a reserve currency has been limited by its volatility, while the pound has been kept out of the running in China by a self-imposed focus on currencies tied to larger economies.

"They’ve got their blinkers on, that it needs to be an economy with 300 million people, with deep, broad capital markets, and there are only really two that have fit the bill over the last 10 years," said Brian Jackson, senior emerging markets analyst at RBC Capital Markets in Hong Kong. However, he said, Europe’s woes have encouraged SAFE and other investors to look beyond their traditional preferences.

Still, while many investors fleeing Europe worry about a renewed recession in the US, they have flocked not to British or Japanese sovereign debt, but to US Treasury bonds. Yields on benchmark 10-year Treasury notes in late May to their lowest levels in more than a year, suggesting the end of the de facto US-eurozone sovereign debt duopoly is not yet near.

Certainly, China will not be providing an alternative on its own. Last year, among talk of the end of the US dollar as a global reserve currency, some officials and commentators spoke of using the renminbi as a new regional and global standard.

Since then, Beijing has continued to encourage the spread of the renminbi through specific currency deals with other nations, with the primary intention of facilitating two-way trade. It has done little, however, to address the renminbi’s fundamental problem and obstacle to use as a reserve currency – namely, a lack of convertibility.

Taking the long view

Meanwhile, the introduction of a new global reserve alternative based on the IMF’s special drawing rights (SDRs), mooted last year by Zhou Xiaochuan, remains constrained by the same issues it was then. The IMF and individual countries could begin to issue SDR-denominated debt, but any change would take place over years: The amount of debt issued would initially be very small compared with existing stocks of euro- and dollar-denominated government bonds.

"It’s dropped off the radar," said RBC’s Jackson. "We thought at the time that it wasn’t really a credible alternative and that’s still our view."

The truth may be that China is not actively looking for alternatives. The debt crisis in Europe is still young, and China’s foreign exchange regulator must take a long-term view. Last year’s criticisms of the US dollar may have given the impression that SAFE responds to short-term currency fluctuations, but Leung at DBS says the opposite is true.

"It’s very important to note that SAFE is very different from fund managers," he said. "They’re the managers of the country’s wealth, and their investment horizon is much, much longer."

Furthermore, China can choose to stay in Europe while concentrating on more secure euro assets, reflecting a change from a mindset that Jackson said treated Greek and German bonds as equals.

But considering that even reducing its rate of purchasing could have harmful consequences for the euro, any more drastic move is out of the question for SAFE. The potential impact – an even weaker European currency, worsening market jitters and, in the worst case, the fallout from a potential collapse of the euro system – make China’s continued support the least bad option, even if the value of its euro-denominated assets falls in the short term.

"What else can it buy?" said DBS’s Leung. "There are no risk-free investments in this world anymore."

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